1.
Chapter 5
Comparability Analysis
Table of Contents
Section # Topic Page
1 Rationale for Comparability Analysis 2
2 Comparability Analysis Process 4
3 Comparability Analysis in Operation 5
 Understanding the economically significant characteristics of the 5
industry, taxpayer’s business and controlled transactions
 Examination or comparability factors of controlled transaction 7
 Location savings 26
 Selecting the tested party(ies) 33
 Identifying potentially comparable transactions ‐ internal and 39
external
 Comparability adjustments where appropriate 46
 Selection of most appropriate transfer pricing method 52
 Determination of an arm's length price or profit (or range of prices or 53
profits)
 Documentation of comparability analysis and monitoring 53
4 Issues regarding comparability analysis 53
5 Conclusion 64
1

2.
5.1 Rationale for Comparability Analysis
5.1.1. The phrase “comparability analysis” is used to designate two distinct though related analytical
steps:
 An understanding of the economically significant characteristics of the controlled transaction,
i.e. the transaction between associated enterprises, and of the respective roles of the parties to
the controlled transaction. This is generally performed through an examination of five
“comparability factors”, as discussed below.
 A comparison between the conditions of the controlled transaction and conditions in
uncontrolled transactions (i.e. transactions between independent enterprises) taking place in
comparable circumstances. The latter are often referred to as “comparable uncontrolled
transactions” or “comparables”.
5.1.2. This concept of comparability analysis is used in the selection of the most appropriate transfer
pricing method to the circumstances of the case, as well as in applying the selected transfer pricing
method to arrive at an arm’s length price or financial indicator (or range of prices or financial indicators).
It thus plays a central role in the overall application of the arm’s length principle.
5.1.3. A practical difficulty in applying the arm’s length principle is that associated enterprises may
engage in transactions that independent enterprises would not undertake. Where independent
enterprises seldom undertake transactions of the type entered into by associated enterprises, the arm’s
length principle is difficult to apply because there is little or no direct evidence of what conditions would
have been established by independent enterprises. The mere fact that a transaction may not be found
between independent parties does not of itself mean that it is, or is not, arm’s length.
5.1.4. It should be kept in mind that the lack of a comparable for a taxpayer’s controlled transaction
does not mean that such transaction is or is not at arm’s length or that the arm’s length principle is not
applicable to that transaction. In a number of instances it will be possible to use “imperfect”
comparables, e.g. comparables from different countries having comparable economic conditions or
comparables from another industry sector, possibly adjusted to eliminate or reduce the differences
between such transaction and the controlled transaction. In other instances where no comparables are
found for a controlled transaction between associated enterprises, it may become necessary to use a
transfer pricing method that does not depend on comparables (see the discussion in Chapter 6). It may
also be necessary to examine the economic substance of the controlled transaction to determine
whether its conditions are such that might be expected to have been agreed between independent
parties in similar circumstances – in the absence of evidence of what independent parties have actually
done in similar circumstances.
2

3. 5.1.5. A controlled and an uncontrolled transaction are regarded as comparable if the economically
relevant characteristics of the transactions being compared and the circumstances surrounding them
are sufficiently similar to provide a reliable measure of an arm’s length result. It is recognized that in
reality two transactions are seldom completely alike and in this imperfect world perfect comparables
are often not available. One must therefore use a practical approach in ascertaining the degree of
comparability between controlled and uncontrolled transactions. To be comparable does not mean that
the two transactions are necessarily identical, but that either none of the differences between them
could materially affect the arm’s length price or profit or, where such material differences exist, that
reasonably accurate adjustments can be made to eliminate their effect. Thus, in determining a
reasonable degree of comparability, adjustments may need to be made to account for certain material
differences between the controlled and uncontrolled transactions. These adjustments (which are
referred to as “comparability adjustments”) are to be made only if the effect of the material differences
on price or profits can be ascertained with sufficient accuracy to improve the reliability of the results.
5.1.6. The aforesaid degree of comparability is typically determined on the basis of a number of
attributes of the transactions or parties that could materially affect prices or profits and the adjustment
that can be made to account for differences. These attributes, which are usually referred to as the five
comparability factors, include:
 characteristics of the property or service transferred;
 functions performed by the parties taking into account assets employed and risks assumed, in short
referred to as the “functional analysis”;
 contractual terms;
 economic circumstances; and
 business strategies pursued.
5.1.7. Obviously, as the degree of comparability increases, the number and extent of potential
differences that could render the analysis inaccurate necessarily decreases. Also, in general, while
adjustments can and must be made when evaluating these factors so as to increase comparability, the
number, magnitude and the reliability of such adjustments may affect the reliability of the overall
comparability analysis.
5.1.8. It is important to note that the type and attributes of the comparables available in a given
situation typically determine the most appropriate transfer pricing method. In general, closely
comparable products (or services) are required if the comparable uncontrolled price ("CUP") method is
used for arm's length pricing; the resale price, the cost‐plus method and the transactional net margin
method (TNMM), may be appropriate if the functional comparables are available, i.e. where the
functions performed, assets employed and risks assumed by the parties to the controlled transaction are
sufficiently comparable to the functions performed, assets employed and risks assumed by the parties
to the uncontrolled transaction so that the comparison makes economic sense. An example would be
two comparable distributors of consumer goods of the same industry segment, where the goods
distributed may not be exactly the same, but the functional analyses of the two distributors would be
comparable. This issue is further discussed in the chapter on transfer pricing methods.
3

4. 5.1.9. Practical guidance is needed for cases without sufficient comparables. There seems to be two
distinct problems relating to comparables for developing countries. The first relates to the inability to
effectively access existing sources, such as existing non‐local company databases. The second relates to
the lack of reliable local country comparables. For each of these, there are problems associated with
both administration (e.g., how the lack of data impedes the reliable and efficient determination of
appropriate arm’s length results) and problems associated with double tax/dispute avoidance (e.g., how
the lack of appropriate data impedes a developing country’s ability to reach agreement with other tax
authorities, or prevent the developing country from being taken advantage of).
5.1.10. The 2010 version of the OECD Transfer Pricing Guidelines points out that non‐domestic
comparables should not be automatically rejected merely because they are not domestic. The guidelines
further recommend that where independent transactions are scarce in certain markets and industries a
pragmatic solution may need to be found on a case‐by‐case basis.1 This means that when the data is
insufficient, stakeholders can still use them as comparables, after in‐depth adjustments are made, to
assess the arm’s length price. The validity of such procedures depends heavily on the accuracy of the
comparability analysis as a whole.
5.1.11. This chapter discusses a possible procedure to identify, screen, select and adjust comparables in
a manner that enables the taxpayer or tax administration to make an informed choice of the most
appropriate transfer pricing method and apply tat method correctly to arrive at the appropriate arm’s
length price or profit (or range of prices or profits).
5.2 Comparability Analysis Process
5.2.1. A typical approach that can be followed while performing a comparability analysis is outlined
below. The steps below are by no means exhaustive but rather suggest an outline based on which a
comparability analysis could be carried out. It may be noted that the process is not linear, for example a
number of the steps may need to be carried out repeatedly until a satisfactory result is achieved. The
subsequent sections of this chapter deal with each of these steps in more detail:
 Understanding the economically significant characteristics of the industry, taxpayer’s business and
controlled transactions
o 5.2.1.1.1. Gathering of basic information about the taxpayer
o 5.2.1.1.2. Transaction analysis
o 5.2.1.1.3. Evaluation of separate and/ or combined transactions
 Examination of comparability factors of the controlled transaction
o 5.2.1.2.1. Characteristics of the property or service transferred
o 5.2.1.2.2. Functional analysis of the controlled transaction under examination
1
The 2010 OECD Transfer Pricing Guidelines para.3.35 and para3.38
4

5. o 5.2.1.2.3. Contractual terms of transaction
o 5.2.1.2.4. Economic circumstances of transaction
o 5.2.1.2.5. Business strategies of parties
 Selecting the tested party(ies) (if applicable)
 Identifying potentially comparable transactions ‐ internal and external
 Comparability adjustments where appropriate
 Selection of most appropriate transfer pricing method
 Determination of an arm's length price or profit (or range or prices or profits)
 Documentation of comparability analysis and monitoring.
5.3. Comparability Analysis in Operation
5.3.1. Understanding the economically significant characteristics of the industry, taxpayer’s business
and controlled transactions
5.3.1.1. Gathering of basic information about the taxpayer
5.3.1.1.1. A precursor to transfer pricing analysis is the collection of background information
about the taxpayer to understand its business operations and activities. This fact‐finding process should
include the identification of associated enterprises involved in the controlled transaction, identification
of the taxpayer’s cross border controlled transactions, information about cross border controlled
transactions (nature of products/ services transferred, type of intangibles used, value thereof, terms and
conditions, etc.).
5.3.1.1.2. An analysis should be performed of the taxpayer’s circumstances including but not
limited to an analysis of the industry, competition, economy, regulatory factors and other elements that
may significantly affect the taxpayer and its environment. This analysis is by nature specific to each
taxpayer and industry.
5.3.1.1.3. Information about the taxpayer from its annual report, product brochures, news
articles, research reports prepared by independent agencies, management letters and internal reports
could act as a good starting point for understanding the taxpayer’s circumstances. A study of these
documents will provide an idea of the industry to which the enterprise belongs, the nature of its
business activities (i.e. manufacturer, wholesaler, distributor, etc.), its market segment, market share,
market penetration strategies, type of products / services dealt in, etc.
5.3.1.2. Transaction analysis
5.3.1.2.1. The arm’s length price must be established with regard to transactions actually
undertaken. The tax authorities should not substitute other transactions in the place of those that have
actually happened and should not disregard those transactions actually undertaken, except in
5

6. exceptional circumstances such as where the economic substance of the transaction differs from its
form, or where the arrangements viewed in their totality are not commercially rational and practically
impede the tax administration from determining an appropriate transfer price. In general, restructuring
of transactions should not be undertaken lightly as this would create significant uncertainty for
taxpayers and tax administrations; this may also lead to double taxation due to the divergent views
taken by countries on how the transactions are structured. The ability of tax authorities to do so will in
any case depend on their powers under applicable domestic law. These issues are relevant for
developing domestic transfer pricing legislation at the beginning of a country’s transfer pricing “journey”
and also to the administration of transfer pricing.
5.3.1.3. Evaluation of separate and combined transactions
5.3.1.3.1. An important aspect of transfer pricing analysis is whether this analysis is required to be
carried out with respect to a taxpayer’s individual international controlled transactions or a group of
international controlled transactions having a close economic nexus.
5.3.1.3.2. Ideally transfer pricing analysis should be made on a transaction by transaction basis.
However, there are cases where separate transactions are so closely linked that such an approach would
not lead to a reliable result. Where transactions are so closely interrelated or continuous that
application of the arm’s length principle on a transaction‐by‐transaction basis would become unreliable
or cumbersome, transactions are often aggregated for the purposes of the transfer pricing analysis.
5.3.1.3.3. Take the example of transactions involving the licensing of know‐how to associated
manufacturers together with the supply to the licensed associated manufacturers of components
needed to exploit such know‐how. In such a case, the transfer pricing analysis may be more reliable if it
takes into account both the license and the supply of components together, than if it looks at each
separately without recognising that they are closely interrelated transactions. Similarly, long‐term
service supply contracts and pricing of closely linked products are difficult to separate out into individual
transactions.
5.3.1.3.4. Another important aspect of combined transactions is the increasing presence of
composite contracts and “package deals” in an MNE group. A composite contract and/or package deal
may contain a number of elements including leases, sales and licenses all packaged into one deal.
Generally, it will be appropriate to consider the deal in its totality to understand how the various
elements relate to each other, but the components of the composite package and/or package deal may
or may not, depending on the facts and circumstances of the case, need to be evaluated separately to
arrive at the appropriate transfer price. In certain cases it may be more reliable to allocate the price to
the elements of the package or composite contract.
5.3.1.3.5. Aggregation issues also arise when looking at potential comparables. Since third party
information is not often available at the transaction level, entity level information is frequently used in
practice when looking at external comparables (e.g. in the absence of reliable internal comparables).
6

7. (“External comparable” and “internal comparable” are defined in para 3.4.1 below). It must be noted
that any application of the arm’s length principle, whether on a transaction‐by‐transaction basis or on
an aggregation basis, needs to be evaluated on a case‐by‐case, applying the most appropriate transfer
pricing method to the facts in that particular case.
5.3.2. Examination of comparability factors of the controlled transaction
5.3.2.1. Characteristics of the property or service transferred
5.3.2.1.1. With that background, an important step is to analyse the relevant characteristics of the
property or service transferred. Property, tangible or intangible, as well as services, may have different
characteristics which may lead to a difference in their values in the open market. Therefore these
differences must be accounted for and considered in any comparability analysis of controlled and
uncontrolled transactions. Characteristics that may be important to consider are:
(i) In the case of tangible property the physical features, quality, reliability and availability and the
volume of supply;
(ii) In the case of services, the nature and extent of such services; and
(iii) In the case of intangible property the form of the transaction (e.g. licensing or sale) and the type
and form of property, duration and degree of protection and anticipated benefits from use of
the property. For example, comparability analysis should take into account the differences
between trademarks and trade names that aid in commercial exploitation (marketing
intangibles) as opposed to patents and know‐how (trade intangibles).
5.3.2.2. Functional analysis
5.3.2.2.1. Functional analysis typically involves identification of ‘functions performed’, ‘assets
employed’ and ‘risks assumed’ (also called “F.A.R. analysis”) with respect to the international controlled
transactions of an enterprise. Functional analysis seeks to identify and compare the economically
significant activities and the responsibilities undertaken by the independent and the associated
enterprises. An economically significant activity is one which materially affects the price charged in a
transaction and/or the profits earned from that transaction.
5.3.2.2.2. Functional analysis is the cornerstone of any transfer pricing exercise and its purpose is
to gain an understanding of the operations of an enterprise with its associated enterprises and of the
respective roles of the parties to the controlled transaction under examination, as these will affect the
determination of an arm’s length remuneration for the transaction. This is because in transactions
between two independent enterprises, compensation will usually reflect the functions that each
enterprise performs, taking into account assets employed and risks assumed. The more valuable those
functions, assets and risks, the greater the expected remuneration.
7

8. Functional analysis is also essential to the identification of potential comparables, as the search for the
latter will generally focus on uncontrolled transactions that present a similar allocation of functions,
assets and risks between the parties.
5.3.2.2.3. Functional analysis is a process of finding and organizing facts about the transaction in
terms of the functions, risks and assets in order to identify how these are divided between the parties
involved in the transaction. The functions, risks and assets are analysed to determine the nature of
functions performed, degree of risks undertaken and the kind of the assets employed by each party.
This analysis helps to select the tested party (ies) where needed (as explained in section C below), the
most appropriate transfer pricing method, and the comparables, and ultimately to determine whether
the profits (or losses) earned by the entities are appropriate to the functions performed, assets
employed and risks assumed.
5.3.2.2.4. The functional analysis is important because the expected return of the entities involved
in a transaction depends on the importance of the functions performed, the degree of risks undertaken
and the nature and value of assets employed. Generally, the more valuable the functions performed,
assets employed and risks assumed by a party to a transaction the greater its expected return (or
potential loss). It is therefore extremely important to map the functions performed, assets employed
and risks assumed by all the associated enterprises in relation to the controlled transaction under
examination.
5.3.2.2.5. A clearer understanding of functional analysis may gained from an example2 which can
be examined in detail below.
Further, hypothetical examples for illustration purposes concerning the different types of international
transactions listed below are given with a view to explaining the chapter in a more practical manner. The
situations are:
1. Manufacturing of products by XYZ & Co, where the technology is owned by an associated
enterprise ABC & Co; and
2. Distribution by A Co of products imported from an associated enterprise B Co for sale in A Co’s
country.
These examples are provided in the Annex at the end of the chapter as Exhibit 1 and Exhibit 2 with a
view to understand the FUNCTIONAL ANALYSIS in a more practical manner. A Co is a company
incorporated and registered under the laws of Country A. A Co is the Intelligent Energy Solutions
Company and is a market leader in the development, production and supply of electronic meters and
their components, software, energy monitoring, billing solutions and payment systems. A Co owns
technologies related to electronic energy meters. A Co is a part of Entity, the largest metering
consortium in the world which shares technology and pools the extensive experience of development
2
Disclaimer: Any resemblance to any case (past, present or future) is purely coincidental and the example is for
illustration only as the example identifies a particular product or industry segment (electronic meters). Each FAR
analysis has to be done on the facts of each individual case.
8

9. and manufacture within a network covering over thirty countries. A Co has an established marketing
network in many developed and developing countries.
B Co is a company incorporated and registered under the laws of Country B and is a wholly owned
subsidiary (WOS) of A Co. B Co intends to manufacture a wide range of electronic energy meters and
portable calibrators, which would cater to all segments of the power generation, transmission,
distribution and consumption sectors and offers similar features required for electricity revenue
management. However such meters will have to be customised to cater to the needs of domestic users.
Such adaptations would be carried out by B Co in its own R&D facilities.
B Co entered into a license agreement with A Co to source its core technology, TECHNO A™ ‐ developed
and patented by A Co. TECHNO A™, being software driven, allows cost effective product feature
enhancements and provides flexibility to utilities to effectively manage electricity revenue and demand,
thereby limiting or eliminating revenue losses. TECHNO A™ technology was developed in Country A by A
Co. TECHNO A™ technology measures electricity flow using digital and microprocessor based techniques
and processes the measurements into useful information. Use of TECHNO A™ technology has major
advantages in the design and manufacture of meters.
With the above background in place the controlled transactions between B Co and A Co are the
purchase of certain components and the license of technology from A Co. As mentioned earlier, A Co is
specialised in dealing with processors and other components of electronic meters and their sub‐
assemblies. These are critical components of an electronic meter. B Co manufactures energy meters in
Country B and uses processors and related components purchased from A Co. Post‐manufacturing B Co
sells energy meters to A Co, in line with its requirements. B Co has its own R&D centre which tries to
increase its performance by improving the technologies so as to achieve further efficiencies. This would
mean that dependence on outside sources for technologies would be reduced in future and cost savings
could be achieved. Also B Co has penetrated the market in the territory of country B by incurring huge
marketing expenditure to establish its own marketing intangibles. These are separate from the
intangibles of A Co. in Country A for which a technology license agreement is in place with A Co.
In the following paragraphs a possible process is described on how FUNCTIONAL ANALYSIS can be
carried out and documented in the given example.
For the purpose of the FUNCTIONAL ANALYSIS in the following paragraphs a qualitative description of
the intra‐group transactions and circumstances between A Co and B Co in relation to the purchase of
components and raw materials can be described by symbols as follows:
9

10.
Symbol Comparative risk Comparative functional Comparative asset level
level standards level standards standard
_ No Exposure No Functions No assets
® Lowest Exposure Least Functions Few assets
®® Medium Exposure Lesser Functions Medium assets
®®® Highest Exposure Highest Functions Most assets
The use of these symbols provides a tool to summarize key aspects of a functional analysis, and to
qualitatively compare the different enterprises in a multinational group across a number of categories
related to functions, assets, and risks, based solely on the facts of a particular case. This tool, commonly
referred to as a “tick chart,” is used extensively in Chapter 5 and in the Annexure to Chapter 5. Tick
charts, while very useful, are inherently subjective. Accordingly, the same set of facts in the hands of
two different analysts may not result in identical tick charts. Caution should be used in giving tick charts
quantitative significance. For example, three ticks do not reflect three times more value than a single
tick. Moreover, all categories in the chart do not have equivalent weight. Accordingly, tick charts should
primarily be used as a tool in evaluating qualitative aspects of the analysis, and should not be used
mechanically to split profits according to the relative number of ticks.
(a) Functions performed
5.3.2.2.6. Functions performed are the activities that are carried out by each of the parties to the
transaction. In conducting a functional analysis economically significant functions are to be considered,
as such functions add more value to the transactions and are therefore expected to fetch higher
anticipated returns for the entity performing such functions. Thus, the focus should not be on
identifying the maximum number of functions but rather on identification of critical functions
performed by the associated enterprises.
5.3.2.2.7. Some of the important functions that are generally observed and examined in a
transaction are:
 Research and development;
 Product design and engineering;
 Manufacturing, production and process engineering and design work;
 Purchasing and materials management and other procurement activities;
 Manufacturing, production or assembly work;
 Transportation, warehousing and inventory;
10

11.  Marketing, advertising, publicity and distribution;
 Market intelligence on technological developments; and
 Intra‐group services, for example managerial, legal, accounting and finance, credit and
collection, training and personnel management services.
5.3.2.2.8. It should be emphasised that this list is purely indicative, and that the extent to which
each of these functions (or other functions not listed above) is economically significant and contributes
to the creation of value depends on the industry and on the taxpayer‐specific circumstances.
A typical check list is annexed to the chapter as Exhibit (3).
5.3.2.2.9. Functional analysis can be approached by evaluating all the economically significant
activities performed in relation to the controlled transaction under examination (such as the list
indicated above) and in potentially comparable uncontrolled transactions. In general, a taxpayer should
prepare this list for both parties to the relevant controlled transaction (e.g. for the producing and
selling/distributing activities) to ultimately support the selection of the most appropriate transfer pricing
method.
5.3.2.2.10. Continuing the example in para 3.2.2.5, the following are the functions performed by
the respective parties.
Functions performed by A Co
With respect to the sale of technology and components of electronic energy meters:
It is assumed that in the context of the sale of electronic energy meters by B Co on the basis of the
technological support of A Co, A Co performs the following economically significant functions [Caution:
this example is for illustration only, and each case should be judged on its own merits]:
 Market development: A Co shares its expertise with B Co and assists in developing
presentations to be made by B Co to the utilities for the development of markets.
 Product development: A Co undertakes the product development activities based on
the concept developed and offered by it to the utilities. Product development involves
product engineering, designs, development or customization of microprocessors,
observance of international standards and national standards for the product etc.
 Quality control: A Co undertakes quality control processes in order to ensure that the
products manufactured by B Co conform to contractual specifications and international
and national quality standards before the products are delivered to utilities and other
customers. This is a critical activity because failure to ensure quality control may invite
11

12. reputational risk and product liability risk.
Functions performed by A Co in relation to the import / purchase of raw materials / components by B Co:
Functions performed by A Co with respect to the purchase of components by B Co:
It is assumed that, in the purchase of processors and other components by B Co from A Co, the
economically significant functions performed by A Co can be summarized as follows : [Caution: this
example is for illustration only, and each case should be judged on its own merits]
 Market development;
 Market intelligence on technological developments;
 Research and development activities;
 Production planning;
 Inventory management;
 Manufacturing;
 Testing and quality controls;
 Selling and distribution activities;
 Post sales activities including replacements; and
 Technical assistance, wherever required.
 Functions performed by B Co
It is assumed that the functions of B Co in the context of the purchase of components and subsequent
sale to domestic utilities are as follows.
[Caution: this example is for illustration only, and each case should be judged on its own merits]
 Market development: B Co undertakes the market development activities. The market
development activities primarily include development of the selling concept (i.e.
identifying how the company can offer a customized solution to a utility having regard
to the specific issues being faced by the utility concerned). B Co makes sales
presentations to utilities and governments and liaises with them for concept selling.
Based on acceptance of the concept, pilot orders for the meters are procured by B Co. It
also participates in the tendering process to procure full commercial orders for the
12

13. energy meters once the pilot runs successfully. B Co also carries out activities in relation
to advertisement, appointment of distributors, commission agents, sales promotion,
market research and marketing strategies. Also B Co has developed the market for the
new product in the territory of country B by incurring sizeable marketing expenditure to
establish its own marketing intangibles that are separate from the intangibles of A Co. in
Country A.
 Research and development: B Co has its own R&D centre which tries to boost its
performance by improving the technologies so as to achieve further efficiencies,
reducing dependence on outside technologies in future and achieving cost savings.
 Production Scheduling: The production by B Co is based on orders obtained from
domestic utilities. The procurement process for the various raw materials/inputs is based
on prudently prepared sales forecasts. The procurement function and the ordering
processes are looked after by the ‘materials department’. Factors like lead time,
availability, negotiations, etc. are taken into consideration while deciding the party from
which a particular raw material/input is to be purchased.
 Tooling: The tooling activities in relation to the products to be produced are undertaken
by B Co. Different products may require different tooling. Different contract
specifications may require different tooling.
 Assembly: This involves the assembling of components. Assembly operations are
mechanical as well as manual. The activity involves mounting SMT components, manual
inspection of placements of the components, computerised shouldering of mounted
components, manual inspection of the shouldering process, mounting of PTA
components manually, etc.
 Intelligence loading: Intelligence loading refers to the process of loading software and
other intelligence features on the manufactured meter. B Co undertakes this activity
based on the technology and microprocessor specification of the contract.
 Testing: Testing and quality controls are critical processes in the manufacture and
marketing of electronic meters. B Co performs testing and A Co undertakes quality
control measures. Testing activity involves temperature variation testing, testing of
manufactured meters against standard meters etc.
 Packaging: B Co packs the products into specially designed containers of various sizes
13

14. depending on the consignment. The containers are in the form of cartons and pallet
packaging. After packaging, products are delivered to domestic utilities.
 Post sales activities: depending on the contracts with the customers, B Co undertakes
installation and commissioning activities wherever required under the contracts. It is
also responsible for the collection of payments from customers. Contractual and non‐
contractual product warranties are provided to customers. Any replacement or further
activities required pursuant to product performance warranties are also undertaken by
B Co.
 Inventory management: B Co is responsible for managing the procurement of raw
materials/components and maintaining the requisite stock levels for the products
including finished goods. As raw materials are generally product specific and the finished
products are manufactured against the confirmed orders from domestic utilities, no
substantial inventory management is involved.
General Management Functions
In the above example the functions addressed below are common functions that are carried out by any
business irrespective of its size and type. These functions are drivers of every business and are
indispensable in the economic environment.
 Corporate Strategy Determination: Generally, all policies within the Multi National
Enterprise group are determined by the management of the respective entities which
continuously monitor the economic environment surrounding the entity, assess their
strategic position within the industry and set targets to achieve their corporate
objectives.
 Finance, Accounting, Treasury and Legal Functions: The management of the respective
entity is responsible for managing the finance, treasury, legal and accounting functions.
Each entity is also responsible for all local statutory compliance.
 Human Resource Management Function: The HR function of each entity is co‐ordinated
by its management, which is responsible for recruitment, development and training of
the personnel including the emolument structure.
14

15. Qualitative relative assessment of functions performed by A Co and B Co with respect to B Co’s
market
LEVEL OF INTENSITY
CATEGORY
A Co B Co
Market development ® ®®®
Product development ®®® ®®
Manufacturing ‐ ®®®
Quality control ®® ®®®
Post sales activities ‐ ®®®
General management Functions
Corporate strategy determination ® ®®®
Finance, accounting, treasury and legal ‐ ®®®
Human resource management ‐ ®®®
(b) Assets employed
5.3.2.2.11. One needs to identify the significant assets (tangible as well as intangible) used by, or
transferred between, the associated enterprises in the course of an international controlled transaction.
5.3.2.2.12. The analysis should involve the identification of the type of capital assets employed (e.g.
plant and equipment, intangible assets, financial assets, etc.) and their significance to the controlled
transaction. For economically significant assets it may be necessary to perform a more detailed analysis
of the assets employed, such as their age, location, property right protections available, market value,
etc.
In the case of capital‐intensive industries, the employment of a capital asset such as property, plant and
equipment, etc. is costly and has to be financed either internally or externally. However, there can also
be cases where the entities are involved in activities for which the assets employed may not require
huge capital investment. Depending on the applicable accounting standards, interest expenses are
sometimes treated as operating expenses (“above the line”) or as financial expenses (“below the line”).
Where interest expenses are treated as operating expenses in the accounts of the taxpayer and/or of
the comparable, they will be addressed in the comparability analysis. Adjustment might be required to
15

16. ensure consistency of accounting standards between the controlled transaction and the comparable.
Differences in the use of assets can be eliminated or reduced to a significant extent by making
comparability adjustments on account of working capital or capacity utilization.
5.3.2.2.13. It is also essential to know which entity or entities has / have the legal ownership of the
intangibles. Note that in some cases an enterprise which does not have legal ownership of an intangible
may nevertheless be entitled to share in the return from its exploitation. Some countries refer to this
notion as “economic ownership”. For instance, where a MNE parent has legal ownership of a product
trade mark or trade name it may have to be determined, depending on the facts and circumstances of
the case, whether the subsidiary has “economic ownership” of the associated marketing intangibles that
are created based on the subsidiary’s contribution to a strategy to enhance market share.
5.3.2.2.14. Continuing the above example in para 3.2.2.5, the following are the assets employed by
the respective parties.
Tangible assets owned by B Co
It is assumed for the purpose of the example that B Co owns the following tangible assets:
 Land & Buildings;
 Plant & Machinery;
 R&D Equipment;
 Office Equipment;
 Furniture and Fixtures;
 Vehicles;
 Computers; and
 Testing Equipment.
Intangible asset ownership
It is assumed for the purpose of the example that B Co has established a research and development
department which tries to increase the level of its performance by improving technologies so as to
achieve further efficiencies. This would also reduce dependence on outside sources of technology in the
future and achieve cost savings. The department also conducts research and development (R&D)
programmes to support B Co’s business and to provide technical assistance to its customers. These
efforts help to increase production efficiency and product quality.
It is assumed for the purpose of the example that B Co has established its own marketing intangibles in
Country B by incurring significant expenditure on marketing and has penetrated the market for the new
product in the territory of country B. These marketing intangibles are separate from the intangibles of A
Co. in country A for which a technology agreement is in place with A Co.
It is assumed for the purpose of the example that A Co is the market leader in the development and
supply of electronic meters, software, energy monitoring, billing solutions and payment systems. Over
16

17. the years it has amassed a wealth of proprietary technical knowledge. This includes product
specifications, designs, the latest manufacturing processes and empirical data on the usage of products
by customers in the industry.
It is assumed for the purpose of the example that B Co has entered into a technology license agreement
with A Co for procuring technology for the manufacture of specified products. Thus B Co uses the
process, know‐how, operating/quality standards etc. developed/owned by A Co. B Co leverages value
from these intangibles for continued growth in revenues and profits.
It is assumed for the purpose of the example that A Co enjoys reputation for quality products. In the
international utility markets, product supplies from international players from developed countries are
preferred by the customers and utilities as compared to direct product supplies from suppliers located
in developing countries. B Co leverages on A Co’s established brand name and reputation for high
technology products. A Co’s commitment to quality also provides B Co with an edge while selling
products in the domestic markets.
Summary of Assets Employed
LEVEL OF INTENSITY
CATEGORY
A Co B Co
Tangible assets ®® ®®®
®®®
Intangible assets ®®
‐ Technological
‐ Brand ®®®
‐ Legal ‐
‐ Marketing ‐
®®®
‐
(c) Risks assumed
5.3.2.2.15. Risk is important in the functional analysis and it should be considered together with the
functions and assets. There are two important aspects to risk: how risk is created and which entity
bears the risk. Risk in an MNE is created by the ownership, exploitation or use of assets, or the
performance of functions over time. The next question is which entity bears the risk (see paragraph
3.2.2.17 below for a discussion of the role of contracts in risk allocation). Risk analysis involves the
17

18. identification of the economically significant risks that are assumed by each of the parties to the
transaction. It is commonly understood that the bearing of economically significant risk is related to
anticipation of reward.
5.3.2.2.16. In the open market the greater the economically significant risks assumed by an
enterprise the higher the return that it expects, although the actual return may or may not increase
depending on the degree to which such risks are realised. Conversely, in a case where such risks
undertaken by the enterprise in a transaction are minimal, the return it may expect from such
transactions should normally be lower. It would be expected that this would be the case in a controlled
transaction that satisfies the arm’s length principle.
5.3.2.2.17. An illustrative list of risks assumed by the parties to the transaction is provided below,
however the relevance of each individual risk factor listed below will depend on the nature of the
transaction:
Nature of risks Particulars
1. Financial risk a. Method of funding
b. Fluctuation in interest rates
c. Funding of losses
d. Foreign exchange risk
2. Product risk a. Design and development of product
b. Upgrading / obsolescence of product
c. After‐sales service
d. Risks associated with R&D
e. Product liability risk
f. Intellectual property risk, if any
g. Scheduling risk
h. Inventory risk
3. Market risk a. Development of a market including advertisement and
product promotion, etc.
b. Fluctuation in demand and prices
c. Business cycle risk
d. Volume risk
e. Service incentive scheme risk
f. Asset redundancy risk
4. Collection risk a. Credit risk
18

19. b. Bad debt risk
5. Entrepreneurial risk a. Risk of loss associated with capital investment
b. Single customer risk
c. Risk of losing human capital intangible
6. General business risk a. Risk related to ownership of property
b. Risk associated with the exploitation of a business
c. Inflation risk
7. Country/regional risk a. Political risk
b. Security risk
c. Regulatory risk
d. Risk related to government policies
5.3.2.2.18 It should be emphasised that this list is purely indicative, and that the extent to which
each of these risks (or other risks not listed above) is economically significant and contributes to the
creation of value depends on the industry and on the taxpayer‐specific circumstances. Hence, real life
knowledge of how a particular MNE is functioning and is documented vis‐à‐vis its associated enterprise
(AE) is very crucial in determination of the risk. For instance, not all industries involve the same level of
product liability risk.
5.3.2.2.19. Risk analysis is important because comparability adjustments may need to be made for
differences in risks that are assumed in a controlled transaction as compared to those in an uncontrolled
transaction.
5.3.2.2.20. It is not only necessary to identify the risks but also to identify who bears such risks. The
allocation of risks is usually based on the contractual terms between the parties. However, contracts
between associated enterprises may not specify the allocation of all the risks. Most commonly assigned
risks in the contract are controllable risks, for example inventory risk, bad debts, foreign exchange risk
etc. Market circumstances, price competition, the supply of raw materials, rises in wages etc. are
uncontrollable or less controllable risks, which may not be identified in the contract. Volatility in the
global market in the last decade has demonstrated that these uncontrollable risks are economically
more significant than controllable risks or contractual risks as mentioned above.
5.3.2.2.21. Even where a written contract is in place an analysis of the conduct of the parties is
critical in order to determine whether the actual allocation of risk conforms to the contractual risk
allocation. The allocation of risk under a contract will generally be respected by the tax authorities
unless it is not consistent with the economic substance of the transaction. Parties transacting at arm’s
length would be expected to agree on the allocation of significant risks between them before the
outcome of the risk‐taking is known.
5.3.2.2.22. When analysing the economic substance of a transaction, it is necessary to examine
whether the conduct of the associated enterprises over time has been consistent with the purported
19

20. allocation of risk and whether changes in the pattern of behaviour have been matched by changes in the
contractual arrangements.
5.3.2.2.23. In addition, the contractual allocation of risks should be arm’s length. Where there are
reasonably reliable comparables evidencing a similar allocation of risks between independent parties,
then the allocation of risks between the associated enterprises is regarded as being at arm’s length.
5.3.2.2.24. In the absence of such comparables one relevant, although not determinative, factor
that can assist in the determination of whether the allocation of risk is at arm’s length is the
examination of which party(ies) has (have) relatively more control over the risk. In arm’s length dealings
a party usually bears a greater proportion of the risk from business activities over which it exercises
relatively more control. The components which may be considered to help identify the party which has
control over the risk may include, when examined in relation to that particular risk:
 Core functions.
 Key responsibilities: formulation of policy, formulation of plan, budget, fixation of goals
and targets etc.
 Key decisions: strategic decisions which have greater potential to impact the ability of
an entity to generate profit and the amount of profits.
 Level of individual responsibility for the key decisions. Allocation of power to senior
management or a level below depends upon the location of core functions in the
country of the MNE or subsidiary, their contribution to core components of the various
functions, their authority, their responsibility and the duties included in the
employment contract of the MNE or subsidiary.
Included in the determination of whether the allocation of risk is at arm’s length is the
examination of which party(ies) has (have) relatively more control over the risk. This
can be illustrated by following examples:
Example 1 – Control over risk by parent company
Company A situated in Country Z belongs to an MNE group having operations worldwide through
various subsidiaries. Company A is responsible for the overall research programmes of the group. The
group has two R&D centres operated by Companies B & C, both subsidiaries of Company A, situated in
Countries X & Y respectively
Company A employs a workforce that includes the CEO, CFO, senior management and technical
personnel that provides strategic supervision of the group’s R&D activities. Company A claims that it
controls and takes all strategic decisions with regard to the core functions of Companies B and C.
Company A designs and monitors the MNE’s overall research programs, provides funds needed for R&D
20

21. activities and controls the annual budget for R & D activities of Companies B & C. The CEO, CFO and
other senior management personnel of Companies B and C reside in Countries X and Y and are
technically and functionally competent to take decisions and carry out the R&D activities of Company B
and C, under the overall direction of Company A. The technical manpower needed for R & D activity and
the assets of companies B & C are located in Countries X and Y.
Company A claims that it controls the risk of the R&D activities of its subsidiaries. On inquiry in audit, it
was found that the personnel managing the group’s R&D activities in Company A in Country Z are
technically qualified to take strategic decisions and to monitor the R&D activities of Companies B & C. It
was also demonstrated that in fact substantial controls are exercised by the personnel of Company A. In
addition, Company A has furnished evidence that it has covered the costs of Companies B and C’s R&D
activities in all the instances where such activities did not lead to successful outcomes. It was also noted
that Companies B and C actually perform R&D functions and take strategic decisions required for
performing the core functions of R&D.
In this example, while the actual functions of R & D activities are undertaken in Countries X and Y,
Company A has demonstrated that it has the capability to control, and actually controls, the risks of
unsuccessful R&D activity through its strategic decisions and monitoring activities and through bearing
the losses from unsuccessful R&D programmes. Accordingly, Company A bears the risks associated with
the success or failure of the research activity undertaken by Companies B and C. Companies B and C,
which perform operational R&D activities and take strategic decisions to perform these core functions of
R&D and also bear the related operational risk, should be entitled to an appropriate return for these
functions and risks. Company A, which provides the strategic direction and management of the group’s
R&D activities, funds the group’s R&D activities and exercises control over the risk of unsuccessful R&D
activity should be entitled to an appropriate return for its functions and risks. Hence, Companies B and C
as well as Company A should be entitled to an appropriate return for their functions and risks.
Example 2 – Control over risk by its subsidiaries
Company A situated in Country Z, a low tax/no tax jurisdiction, belongs to an MNE group having
operations worldwide through various subsidiaries. Company B and C, which are both subsidiaries of
Company A, operate R & D centres situated in Country X &and Y respectively having normal tax rates.
Company A which employs a workforce of ten persons including a CEO, CFO and other senior
management claims that it controls and takes all strategic decisions with regard to the core functions of
companies B and C. Company A provides the funds needed for R&D activities and controls the annual
budget for R&D activities of Companies B and C. It also provides technical assistance for registration of
patents in Countries X, Y & Z. The CEO, CFO and other senior management personnel of Company B and
C reside in Countries X and Y and are technically and functionally competent to take decisions and carry
out R&D activities of Company B and C. The technical manpower needed for R & D activity and the R&D
related assets of companies B and C are located in Countries X and Y.
21

22. Company A claims that it controls the risk of the R&D activities of its subsidiaries. On inquiry in audit it
was found that the CEO and CFO and Senior Management of Company A in country Z are technically not
skilled either to take strategic decisions or to monitor the R&D activities of company B and C. Company
A has not furnished any evidence of taking strategic decisions. On the other hand, it was found that the
senior management of Companies B and C are taking the important strategic decisions related to the
design and direction of the R&D programme and budget. However, Company A has furnished evidence
that the funds were actually transferred to its subsidiaries for R&D activities.
In this example all the core functions of R & D activities are located in Countries X and Y and the non‐
core functions of registering patents are located in Country Z. Even though the senior management of
company A are located in Country Z they are not capable of taking strategic decisions or controlling and
monitoring R & D activities. The determination, utilization and control of the budget for carrying out
R&D activities and decisions regarding day‐to‐day performance of R&D activities were carried out by
Companies B and C. In view of these facts it cannot be held that Company A controls the risk of R&D
activities. Company A should be entitled to an appropriate return for the provision of funding and
Companies B and C should be entitled to an appropriate return for their functions including the strategic
decisions and control over the risk of R&D activities.
5.3.2.2.25. In arm’s length transactions another factor, although not a determinative factor, that
may influence an independent party’s willingness to take on a risk is its anticipated financial capacity, at
the time when risk is allocated to it, to assume (i.e. to take on) the risk. If it is anticipated that the party
will not have the capacity to bear the consequences of the risk should it materialise and that it also does
not put in place a mechanism to cover the risk, doubts may arise as to whether the risk would be
assigned to this party at arm’s length. Note that the financial capacity to assume the risk is not
necessarily the financial capacity to bear the full consequences of the risk materialising (e.g. the full
loss), as it may be the capacity for the risk‐bearer to protect itself from the consequences of the risk
materialising (e.g. by hedging the risk or otherwise). Furthermore, a high level of capitalisation by itself
does not mean that the highly capitalised party carries higher risk.
Beyond the identification of these two relevant factors it is not possible to provide prescriptive criteria
that would provide certainty in all situations. The determination that the risk allocation in a controlled
transaction is not one that would have been agreed between independent parties should therefore be
made with care considering the facts and circumstances of each case. It is pertinent to mention here
that in a multinational enterprise associated entities work together to exert control over the risks of the
entire MNE group. Real and precise distribution of risk among the associated enterprises is virtually
impossible to achieve, due to the lack of sufficiently detailed information in some cases. 5.3.2.2.26.
Continuing the example in para 3.15, it is assumed for the purpose of the example that the
following are the risks borne by the respective parties.
[Caution: this example is for illustration only and each case should be judged on its own merits.]
22

23.
Risk Category Exposure of A Co. Exposure of B Co.
Market Risk It is assumed that A Co. has It is assumed that B Co. has
the same level of market risk. significant exposure to this risk
because it is responsible for
the domestic market that it
caters to.
Product liability risk It is assumed that A Co. faces It is assumed that B Co. faces
this risk arising from the product liability risk as a result
product failure, technology of rejection where the
absorption by B Co. and products do not conform to
consequential reputational the order specification given
risk. Further A Co. is primarily by domestic utilities. Risks
engaged in product and arising from non‐conformity
technology development so with customer specifications
this risk is also borne by A Co. or national/ international
product standards are borne
by B Co. However, this risk is
mitigated due to the excellent
quality, safety standards and
processes deployed by B Co.
and its own R&D centre.
Technology Risk It is assumed that A Co. is It is assumed that the
exposed to higher technology manufacturing operations of B
risk, being the technology Co. are non‐complex. Further,
owner. Due to market product technology and know‐
competition and an ever‐ how have been provided by A
changing technology scenario, Co. Hence B Co. does not face
it needs to continuously any major technology risk.
upgrade the existing
technology and develop new
technology to face the market
competition. A Co.
continuously focuses on
providing products with
contemporary technology.
23

24. Research & Development risk It is assumed that since A Co. It is assumed that since no
serves diverse markets, its significant R&D (except for
engineering and R&D supporting B Co’s business and
professionals constantly strive that of providing technical
to provide innovative solutions assistance to its customers) is
that offer competitive carried out by B Co, it faces no
advantages for customers significant risk on this account.
worldwide.
Credit Risk It is assumed that in the case It is assumed that all the major
of inter‐company sales of credit risks associated with
technology and components A sales are borne by B Co.
Co. faces minimal risk.
Inventory Risk It is assumed that A Co. is It is assumed that B Co. is
primarily engaged in product responsible to manage the
and technology development procurement of raw materials
and this risk is not borne by A / components and maintain
Co. the requisite stock levels for
each product including
finished goods. However, this
risk is mitigated to the extent
that components are procured
from A Co.
Foreign Currency Risk It is assumed that A Co. It is assumed that since B Co.
exports technology and imports technology and
components to B Co.; hence components from A Co. and its
they are also subjected to sales are restricted to
appreciation/ depreciation of domestic markets, the imports
local currency2 against the are subjected to
foreign currency. Hence A Co. appreciation/depreciation of
is also subjected to this risk. local currency against the
foreign currency. Hence B Co.
is subjected to this risk.
#
24

25.
Summary of Risks borne by each party
LEVEL OF INTENSITY
CATEGORY
A Co. B Co.
Market risk ** **
Product liability risk ‐ ®®®
Technology risk ®®® ®
Research & Development risk ®®® ®®
Credit risk ‐ ®®®
Inventory risk ‐ ®®®
Foreign currency risk ®® ®®
5.3.2.3. Contractual Terms of transaction
5.3.2.3.1. The conduct of the contracting parties is generally a result of the terms of the contract
between them and the contractual relationship thus warrants careful analysis when computing the
transfer price. Other than a written contract, the terms of the transactions may be calculated from
correspondence and communications between the parties involved. In cases where the terms of the
arrangement between the two parties are not explicitly defined, the contractual terms have to be
deduced from their economic relationship and conduct.
5.3.2.3.2. One important point to note in this regard is that associated enterprises may not hold
each other fully to the terms of the contract as they have common overarching interests, unlike
independent enterprises, who are expected to hold each other to the terms of the contract. Thus, it is
important to figure out whether the contractual terms between the associated enterprises are a “sham”
(something that appears genuine, but when looked at more closely lacks reality, and is not valid under
many legal systems) and/or have not been followed in reality.
5.3.2.3.3. Also, explicit contractual terms of a transaction involving members of an MNE may
provide evidence as to the form in which the responsibilities, risks and benefits have been assigned
among those members. For example, the contractual terms might include the form of consideration
charged or paid, sales and purchase volumes, the warranties provided, the rights to revisions and
25

26. modifications, delivery terms, credit and payment terms etc. In addition to an examination of these
contractual terms, it will be important to check that the actual conduct of the parties conforms to them.
5.3.2.3.4. Where there are material differences in economically significant contractual terms
between the taxpayer’s controlled transactions and the potential comparables, such differences should
be evaluated, in order to judge whether comparability between the controlled and uncontrolled
transactions is nevertheless satisfied and whether comparability adjustments need to be made to
eliminate the effects of such differences.
5.3.2.3.5. An example of how contractual terms may affect transfer pricing is as follows. Consider
Company A in one country, an agricultural exporter, which regularly buys transportation services from
Company B (its foreign subsidiary) to ship its product, cocoa beans, from Company A’s country to
overseas markets. Company B occasionally provides transportation services to Company C, an unrelated
domestic corporation in the same country as Company B. However, the provision of such services to
Company C accounts for only 10% of the gross revenues of Company B and the remaining 90% of
Company B’s revenues are attributable to the provision of transportation services for cocoa beans to
Company A. In determining the degree of comparability between Company B’s uncontrolled transaction
with Company C and its controlled transaction with Company A, the difference in volumes involved in
the two transactions, volume discount if any, and the regularity with which these services are provided
must be taken into account where such factors would have a material effect on the price charged.
5.3.2.4. Economic circumstances of the transaction
5.3.2.4.1. Economic analysis deals with industry analysis and the circumstances that may be
relevant for determining market comparability. The relevant information on the industry can be broadly
classified into following:
 Global economic trends and developments relating to the industry to which the
enterprise belongs;
 Economic trends in each taxpayer’s country for the same industry; and
 Market position of the enterprise and surrounding economic conditions.
Care must be exercised while considering global economic trends, as the market trends in the taxpayer’s
country and in the country of its associated enterprise and/or of the potential comparables (in the case
where foreign comparables are used) could be significantly different. For example in the 2008 meltdown
of the global economy some of the banks and automobile companies reported huge losses globally, but
significant profits in emerging economies. Where there are such significant differences between the
economic circumstances prevailing in different markets such that it is not possible to eliminate them by
making reliable comparability adjustments, then companies from such different markets might not be
retained as reliable comparables.
26

27. 5.3.2.4.2. Undertaking a more detailed classification of the above broad headings would yield the
following specific factors which may need to be looked at in performing an industry analysis if they are
economically significant for the examined controlled transaction:
 Geographic location of the market;
 Market size;
 Level of the market (e.g. retail or wholesale);
 Competition in the market and the relative competitive positions of the buyers and sellers;
 Availability of substitutes;
 Government regulations of the market;
 Levels of supply and demand;
 Consumer purchasing power;
 Location‐specific costs of production including the costs of land, labour, capital, transportation costs
etc.;
 Economic conditions of the overall industry, the key value drivers in the industry and the date and
time of transactions;
 The existence of a cycle (economic, business, or product cycle); and
 Other relevant factors.
5.3.2.4.3. Market prices for the transfer of the same or similar property may vary across different
markets owing to cost differentials and/or differences in purchasing power and habits prevalent in the
respective markets which may affect the market price. Markets can be different for numerous reasons;
it is not possible to itemise exhaustively all the market conditions which may influence transfer pricing
analysis but some of the key market conditions which influence such an analysis are as discussed below.
5.3.2.4.4. Geographical location – in general, uncontrolled comparables should be derived from
the geographic market in which the controlled taxpayer operates, because there may be significant
relevant differences in economic conditions between different markets. If information from the same
market is not available an uncontrolled comparable derived from a different geographical market may
be considered if it can be determined that (i) there are no differences between the two markets that
would materially affect the price or profit of the transaction or (ii) reasonably reliable adjustments can
be made to account for such material differences between the two markets.
5.3.2.4.5. An example of a potential issue relating to geographic location is that of location
savings, which may come into play during a transfer pricing analysis. Location savings are the net cost
savings that an MNE realises as a result of relocation of operations from a high cost jurisdiction to a low
cost jurisdiction. Typically, the possibility to derive location savings may vary from one jurisdiction to
another, depending for example on the following:
 labour costs;
 raw material costs;
 transportation costs;
 rent;
27

28.  training costs;
 subsidies;
 incentives including tax exemptions; and
 infrastructure costs.
It is quite possible that part of the cost savings may be offset at times by “dis‐savings” on account of
poor infrastructure in relation to the quality and reliability of the power supply, higher costs for
transportation, quality control etc. Accordingly, only the net location savings (i.e. savings minus dis‐
savings) may give rise to an extra profit arising to an MNE due to the relocation of its business from a
high cost to a low cost jurisdiction.
5.3.2.4.6. How are location savings measured: The computation of location savings typically involves the
quantification of the net cost savings derived from relocating in a low cost country, as compared to the
relevant high cost country. In theory, the cost savings computation includes selection of a pre‐transfer
manufacturing or servicing base in the relevant high‐cost country compared to the comparable
manufacturing or services cost in the low‐cost country, taking into account such things as total labour
cost per unit of output (adjustment on account of difference in labour productivity), cost of raw
material, costs of land and rent costs; tax benefits etc. The cost savings can be partially offset by higher
cost of infrastructure like less reliable power etc. in certain cases.
Cost savings Dis savings Net location
(e.g. cheap labour) ‐ (e.g. high transportation cost) = savings
5.3.2.4.7. What are location‐specific advantages: The relocation of a business may also (in addition to
location savings) or alternatively give some other location‐specific advantages (in short LSAs). Location
savings and location specific advantages are one type of benefit related to geographical location. These
LSAs could be, depending on the circumstances of the case:
 highly specialized skilled manpower and knowledge;
 proximity to growing local/regional market;
 large customer base with increased spending capacity;
 advanced infrastructure (e.g. information/ communication networks, distribution
system); or
 market premium.
Taken together, location savings and each of the other types of benefit related to geographical location
are called location‐specific advantages [LSAs]. LSAs may play a very important role both in increasing
the profitability of the MNE and in determining the bargaining power of each of the associated
enterprises. It should be noted that the term LSA includes sources of value that are discussed elsewhere
in the Manual, and should not be double counted in assessing arm’s length outcomes.
28